Any kind of security that cannot be traded in public is known as private equity. I have worked in Saudi American Bank (Samba) as a coop student at the private equity desk whereby I have faced some issues with a private equity firm that was hard to handle. The equity firm wanted to invest $100,000 in a small company in Saudi Arabia whose profits had been decreasing significantly over a three-year period. The problem was that the firm’s investment manager was investing for the first time and therefore, he had many questions to ask before he finally made the decision to invest in the company.
I had to advise the client accordingly to convince him to invest in the company. The private equity firm wanted to have majority control in the company so that it could buy it at a lower price and resale it for a higher value. The client then wanted to know the various strategies that can be used to invest.
To help him make a decision, I had to take about one hour to explain all the various strategies available. A leveraged buyout is a strategy that enables the financial sponsor to just agree to acquire a firm without necessarily providing all capital required for the investment. The sponsor is only required to provide a proportion of capital and can always get a share of the returns. The problem with this strategy is that it can only be done by a mature company due to the huge cash flow requirements.
A venture capitalist strategy is used to enable the acquired firm to expand its operations like that of introducing a new product. The acquired firm may not have sufficient fund to support its expansion and therefore may require to be financed by another company. It is very useful for a business that is starting and has insufficient funds. It also applies to the businesses whose technology changes from time to time and therefore may require additional funds to finance its operations.
A mezzanine capital may be used when the investor is not able to obtain huge debts from banks due to a lack of sufficient security. It is very risky since the small company may not be able to repay the loan. An investor shall then require very high returns due to the high risks involved.
A distressing situation involves investing in a company that has financial problems. The acquired companies may need to be rescued from some of the challenges that they are facing financially. The investor can only invest in such firms when he hopes that the firm is likely to recover after some time. It is very risky but the returns are very high if the company recovers. It, therefore, requires risk-takers to invest in such companies.
The investment manager for the company decided to use the buyout strategy. I told him that he had to increase the amount by $200,000. This could enable the investment firm to acquire the majority control over the firm. After accepting my proposal, the manager decided to go back and raise the funds but I advised him to borrow the amount from our bank so that he can take advantage of the underperforming company.
After the firm had borrowed the funds, it bought almost all the shares of the underperforming company and therefore obtained a majority control. After one year, the company improved performance and was sold for $450,000 and therefore the investing firm made a high profit out of the investment. Some of the funds obtained were used to repay the loan. Indeed, my proposal helped the company to invest wisely.